Forex

In the children's book The Cat in the Hat Comes Back, the author Dr. Seuss provides a cautionary tale of unintended consequences. The story involves more than two dozen felines trying to clean up a pink mess in a bathtub, but every time they get it off something, they get more of it on something else.

The folks at the U.S. Securities and Exchange Commission may want to refer to a copy. A proposed SEC rule to prevent bond-rating agencies from signing off on the kind of credit crud that precipitated the subprime mortgage mess seems destined to quash the creativity needed to invent cutting-edge financial products. That would force some borrowers to pay higher rates on creative financings than would otherwise be the case.

Behind the mortgage crisis were funky bonds called collateralized debt obligations.These were built out of other kinds of debt, including obligations made from home mortgages. The resulting mashups were difficult for anybody -- credit-rating agencies and investors alike -- to understand. Based on limited information available about what the CDOs contained, bond raters Fitch, Moody's and Standard & Poor's gave many of them triple-A gradings, indicating that their chances of going bad were remote.

As subsequent events revealed, those rave reviews were ill-advised. (See "Now They Tell Us")

The SEC's proposed solution is to drastically increase the amount of information that bond issuers need to disclose to the public so that the rating agencies can rate them. That seems like a good thing, but there are a couple of drawbacks. For one thing, more information for the raters to peruse means more hours of work. Somebody has to pay for those hours, and that somebody would be the bond issuers.

It might not matter to a somebody selling $10 billion of plain-vanilla corporate bonds, but in a smaller, more complex issue, those costs will add up.

"What the rules clearly address is the very large markets for asset-backed securities such as home mortgages, auto loans and credit card loans. However, these rules could very well hurt liquidity and innovation in little niche markets, which in their aggregate likely provide a lot of liquidity to the U.S. economy," said David Thatch, a securities lawyer and partner at New York-based White & Case. "If regulators increase the cost to rating new financial products - those without a developed market - they might be forcing innovative structures from the ratings regime all together."

Ungraded bonds typically pay higher interest rates than those with good ratings since borrowers have to estimate the safety for themselves.

A more pernicious effect might be to force issuers to disclose trade secrets. If the credit agencies are to base their ratings on publicly available information and the new rules require massive disclosure, then copycats could easily recreate new kinds of bonds.

One possible fix is to allow issuers to disclose information only to the ratings agencies, but that happened with CDOs, and, lacking the light of widespread public scrutiny, the credit reviewers overlooked a lot of damaging data.

The public has until July 25 to comment on the proposals. Kevin J. Callahan, a spokesperson for the SEC, said, "The commission always invites widespread feedback during public comment periods for a proposed rule."